Why Bespoke ETFs Don’t Suit Every Investor

Exchange-traded-fund providers are taking on the role of Savile Row clothiers, tailoring ETFs to the unique specifications of large clients. That’s great news for the parties involved in the transaction, but when retail investors try on the same ETF, they can end up looking like they’re wearing dad’s old suit.

Illustration: Dan Picasso for Barron's

Issuers always have consulted with pension funds, hedge funds, and other big clients before launching new products, but the creation of these so-called bespoke ETFs takes this collaboration to the next level: ETFs are created for a specific investor that quickly pumps tens or even hundreds of millions into the fund, making it look like a substantial fund with a lot more mass appeal and staying power than it actually has.

All told, newly minted bespoke ETFs accounted for $3.4 billion in assets in 2014, or fully 36% of the $9.6 billion held in all ETFs launched in the past year, according to a Barron’s tally of research firm XTF’s data, which include exchange-traded notes.

The rise of bespoke ETFs is in part the result of small ETF issuers finding it more challenging to secure start-up funding from Wall Street banks -- so instead they seek out clients that will guarantee the initial money. Meanwhile, demand is growing from institutions, which see made-to-order ETFs as a means to simplify trading on behalf of clients.

Now, there’s nothing wrong with the practice, per se, but the whole notion raises some issues for individual investors and financial advisors. For starters, bespoke ETFs aren’t labeled as such. Once a bespoke fund is launched, it’s available to everyone, without any indication of why for whom it was created, and any methodology is buried in the prospectus. It’s up to each investor to truly understand how an ETF was constructed, no matter how unique or complicated it may be. One more caveat: Bespoke ETFs often trade very lightly, which can be problematic even if its holdings are very liquid.

Consider two recently launched, nearly identical, low-carbon-emissions-themed ETFs, pushed out last year by State Street Global Advisors and BlackRock. Together, the
SPDR MSCI ACWI Low Carbon Target
(ticker: LOWC) and
iShares MSCI ACWI Low Carbon Target
(CRBN) have gathered $225 million in little over a month. Both were helped to market with tens of millions in start-up cash from the United Nations Joint Staff Pension Fund, a manager of more than $50 billion, coincident with global climate talks held in Peru last month. A separate backer, the University System of Maryland Foundation, kicked millions more into the iShares fund.

Both ETFs aim to deliver baskets of stocks that assign outsize heft to shares of companies that pledge a lighter environmental touch, all while still sticking close to its benchmark. It’s an appealing idea, but early on, there are liquidity questions. Both low-carbon ETFs have featherweight trading volume compared with their impressive size, which could make buying and selling difficult and costly for smaller investors unless more pensions opt in. Despite a rapid influx of cash, median daily trading volume for State Street’s low-carbon ETF since its late-November launch is a paltry 239 shares per day; BlackRock’s low-carbon fund is even less active.

Todd Rosenbluth, director of ETF research at S&P Capital IQ, stresses that a custom-made ETF’s built-in assets can mask potential complications under the hood. He advises potential investors to be on the lookout for other large investors ponying up before buying. “If there’s not money going into it or out, there’s no volume. And if there’s no volume, the spreads will be wide for anyone looking to get in or out,” he says.

MORE QUESTIONS ARISE should the initial institution want out of its investment. After a heavy withdrawal, those left are likely to find less liquidity on the road to ETF closure. “If that money comes from one audience and then leaves, you’re left as the odd man out,” Rosenbluth says.

Last year’s splashiest custom-ETF launch came from New Jersey–based WBI Investments, which oversees $3.2 billion. In August, WBI launched 10 actively managed ETFs that collectively raised more than $1 billion only one day after their launch, according to ETF.com -- a huge feat. WBI vaulted from an unknown in the ETF world to a midtier player in the blink of an eye because big slugs of that money came from its clients. Indeed, since their August launch, WBI’s quantitative ETFs have raked in little additional money and trade little on an average day, versus ETFs of similar size. Signs of tepid outside demand is reason enough for most investors to stay away.

But some bespoke ETFs employ familiar, and popular, strategies. In 2013, the $31 billion Arizona State Retirement System plopped $100 million each into four iShares ETFs that rank stocks based on factors such as momentum and size. After getting a kick-start from the pension, each ETF has managed sturdy performance with low expenses of 0.15%. Led by the $713 million
iShares MSCI USA Quality Factor
(QUAL), these four now collectively hold $2 billion, all of which trade robustly enough.

The upshot is that investors can benefit from this proliferation of bespoke ETFs, but, just as with any ETF debut, it pays to wait for them to season before buying in. A true classic -- be it a suit or an ETF -- is timeless.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.